Corporate Finance: et renegotiation Yossi Spiegel Recanati School of usiness
Gertner and Scharfstein, JF 1991 A Theory of Workouts and the Effects of Reorganization Law
The model The timing: Period Period 1 Period 2 The firm has a cash flow Y < The firm can restructure its det The firm needs to pay to a ank and q to ondholders The firm can invest in a project The firm needs to pay 1-q to ondholders The project yields ~[, The dist. of is fx and the CF is F The mean of is ˆ = df Corporate Finance 3
ank det restructuring Y < q without restructuring the firm cannot invest The firm must raise q-y in period 1 in order to cover The Trust ndenture Act of 1939 requires detholders unanimity to change the interest, principal, or maturity of puic det renegotiation of pulic det is very hard ank det restructuring: the ank gives the firm cash worth q-y so the firm can meet all its oligations in period 1 the face value of the new ank s det is higher to ensure that the ank makes a profit Simplifying assumption: ankruptcy occurs in period 2 iff < 1 q 4243 q Y 14 2443 ank det pulic det This is a simplifying assumption since the face value of the new ank det is actually higher Corporate Finance 4
ank det restructuring period 2 Solvency: > The firm and the ank split 1-q ankruptcy: < q Y 144 2443 14243 New ank det q Y 1 q 1 q = Y Pulic det New ank det Pulic det Corporate Finance 5
Condition for ank restructuring q Y df 14444 244443 Period 2 payoff in ankruptcy 1 q df q Y 144424443 Period 2 payoff in solvency q Y df 14 44 2 4443 1q / 14243 Period 1extra cash outflow Y L 1 44243 4 payoff in period 1 under ankruptcy asent restructuring 1 q df q Y Y = Y L Corporate Finance 6
The ank will agree to restrcture : ˆ 1 q q df 14444444 2 V = the value of 44444444 3 pulic det under restructuring The condition for restructuring: ˆ 123 Expected NPV V 14243 L Transfer to pulic det V -L is positive or negative 1 q df L Corporate Finance 7
nvestment with ank det nvest iff: ˆ V L No investment is efficient nvestment is efficient ˆ V -L >: on t invest nvest V -L <: on t invest nvest We can have underinvestment det overhang or overinvestment asset sustitution Corporate Finance 8
Corporate Finance 9 The effect of pulic det maturity The value of det under resructuring: V = if q = 1 How does q affect V? = df q df q q V 1 1 = > = df df df df q V
The effect of pulic det maturity q V V - L nvestment takes place iff: ˆ V L Since q V, underinvestment is likely when q 1 short maturity and overinvestment is likely when q long maturity No investment is efficient nvestment is efficient ad effect: Good effect: on t invest on t invest nvest nvest ˆ q exacerates underinvestment det overhang ut alleviate overinvestment asset sustitution Corporate Finance 1
New capital infusions from a new ank or y issuing equity nvest iff: ˆ V L L 123 No investment is efficient nvestment is efficient ˆ V -L >: V -L <: on t invest on t invest nvest nvest The new cash infusion exacerates underinvestment det overhang ut alleviate overinvestment asset sustitution. V is even higher if the cash infusion is via equity det has priority over equity during ankruptcy in period 2 The firm will issue det, not equity equity susidizes pulic det and is therefore wasteful Corporate Finance 11
New senior det Suppose the firm can issue in period 1 senior det with face value which is due in period 2 existing det is not protected y seniority covenants f, the firm always defaults in period 2 so the new senior detholders will get the entire period 2 cash flow Existing det gets in period 2 The value of the existing det is only equal to the period 1 payment q < V Corporate Finance 12
New senior det nvest iff: ˆ q L No investment is efficient nvestment is efficient V -L >: on t invest nvest ˆ V -L <: on t invest nvest The new senior det alleviates underinvestment det overhang ut exacerates overinvestment asset sustitution. Seniority covenants which prevent the firm from issuing senior det are worthwhile if overinvestment is likely q ut are a ad idea if underinvestment is likely q 1 Corporate Finance 13
Existing pulic det is junior to ank det f the firm goes ankrupt in period 1, junior detholders get [Y-] < L nvest iff: ˆ V [ Y ] > V L No investment is efficient nvestment is efficient V -L >: V -L <: on t invest on t invest nvest nvest ˆ When existing det is junior, underinvestment det overhang is exacerated likely when q 1 ut overinvestment asset sustitution is alleviated likely when q. Corporate Finance 14
Pulic et Exchange
Pulic det exchange Suppose the firm can restructure its pulic det despite the difficulties through an exchange tender your old det and get a new det or cash The firm faces a cash shortage: { < Y < q 142 43 Money to pay ank and invest Money needed to stay solvent in period 1and invest Timing: Stage 1: the firm makes TOL offer to the ank Stage 2: the firm offers an exchange of existing pulic det with new pulic det due in period 2 whose face value is p investors who refuse keep their old securities Corporate Finance 16
Pulic det exchange stage 2 Suppose the ank rejects the TOL The firm offers an exchange of existing pulic det with new senior pulic det due in period 2 and with face value p The firm can set p s.t. old detholders get nothing in period 2 Suppose that ˆ Y q { ˆ 14243 4 q Y Max. period 2 payoff of new pulic detholds they get everything since p is set high Period 1 payoff of detholders who reject the exchange their period 2 payoff is since p is high f the condition holds, then there exists an equil. in which all pulic detholders accept f the condition holds, the ank gets if it rejects the TOL to induce the ank to accept the TOL, the firm must offer the ank at least Corporate Finance 17
ank det restructuring in stage 1 The restructured ank det,, is senior to pulic det The firm makes a TOL to the ank s.t.: ' Rewriting: ' df ' df Y q = { 142 43 ' The 14243 14243 New cash infusion if - The ank gets the first dollars up to ' The ank is paid in full in period 2 Cash payment if anks' alternative Y q df = ' Y q The ank accepts the TOL only if satisfies the aove equation ' df Corporate Finance 18
ack to pulic det exchange the ank s det remains ˆ q Y Suppose that so the firm can exchange its pulic det Suppose the firm offers new det with face value p p need not e so high that ankruptcy occurs for sure - solvency in period 2: Y-- cash in period 2 p is paid in full p face value of new det Y-- extra cash from period 1 Corporate Finance 19
ack to pulic det exchange the ank s det remains Solvency in period 2 the face value of new det is p: Y1 42 43 Extra cash left from period1 The value of old pulic det: O = q { 1 q df payoff Period 1 14 42443 Period 2 payoff in solvency The value of new pulic det paid only in period 2: p Y N = df pdf 144 44 244443 14243 Pulic det is not paid in full p Y Pulic det is paid in full Corporate Finance 2
Corporate Finance 21 Pulic det exchange The minimal p needed to ensure acceptance is defined implicitly y N = O: Reorganizing, p which ensures that pulic det can e exchanged, is defined y: = df q q pdf df Y 1 = df p df q Y 1
Summary The ank accepts the TOL only if satisfies: ' Y q df = ' Y q ' df Pulic detholders accept the pulic det exchange only if p satisfies: Y q df = 1 p df Corporate Finance 22
Exchange or restructure? Equityholders payoff: n a pulic det exchange: [- ], where p-y n ank det restructuring: [- -1-q] Exchange is more profitale iff < ' 1 q ' > { py 1 q We ll show that this inequality holds y writing = -1-qε and showing that ε > Corporate Finance 23
Corporate Finance 24 Exchange or restructuring of? The condition for ank det restructuring: Recall that -1-qε and p-y. Then the RHS ecomes: = = = = ' ' ' 1 ' ' 1 1 ' p q x df p df Y df q Y q Y p df q Y ε ε ε ε 4748 6 4444 4 3 4444 14 2 4 4 8 4 64 7 = ' ' ' df q Y df q Y
Exchange is more profitale The TOL to the ank: ' The condition for pulic det exchange: Y q df = 1 p ε Y q df = 1 p df Suppose that ε <. Then, -1-qε < ' df The LHS of the 2 nd equation is larger ut the RHS of the 1 st equation is larger Contradiction! ε > > -1-q exchange is more profitale Corporate Finance 25